Financial Reform Is About to Catch a Second Wind

And Elizabeth Warren is ready to ride it

Financial reformers seeking new rules beyond the range of the Dodd-Frank law haven’t had much to cheer about this year. The chances of Congress passing new regulations—OK, passing anything—look bleak, and the Obama Administration wants to simply finish implementing the last set of reforms. But reformers are playing a longer game, biding their time until the conditions are ripe for a dam burst. That could happen sooner than you think. High-profile champions for reform are gradually bending regulators to their will, and a pile-up of big bank abuses have eroded Wall Street’s reputation in Washington. Most importantly, a new report detailing the extraordinary largesse granted banks during the financial crisis, and questioning whether Dodd-Frank would prevent a rerun, could set off a fresh spark.

An unlikely bipartisan duo, Senators Sherrod Brown and David Vitter, have tried all year to focus attention in Congress on ending “too big to fail,” the perception that large financial institutions will inevitably receive government bailouts if they run into trouble. This allows banks to take on outsized risks with implicit government support, and receive a de facto subsidy, with lower borrowing costs than their smaller competitors, because investors believe a backstopped institution will always pay them back. Brown and Vitter introduced legislation earlier this year to significantly raise capital requirements, which they say will reduce reliance on bailouts by forcing banks to pay for their own losses.

Brown and Vitter commissioned a study from the Government Accountability Office (GAO) to quantify the public subsidy bestowed on banks, which could give them powerful evidence to rally support for their legislation. GAO released the first part of the study last week. It mostly looks backward at the “extraordinary support” given to banks from 2007-2009 to weather the financial crisis, and whether the Dodd-Frank financial reform law ended this tendency toward bailouts. The more controversial part of the study, on how much the government subsidizes big banks considered too big to fail, isn’t due until next year.

But the report still contains some explosive material. It details how banks received trillions of dollars in capital injections, emergency lending and debt guarantees during the financial crisis, offered with more favorable terms than they could have found in the private market, and secured by junk collateral that non-government lenders would never accept. Some debt guarantees given by government agencies to banks were up to 10 percent cheaper than private alternatives, saving the banks billions of dollars. Banks with over $50 billion in assets used the crisis-era programs nearly twice as much as their smaller counterparts. Outside of the broadly available emergency programs, JPMorgan Chase received a $30 billion loan from the New York Federal Reserve (then run by Timothy Geithner) for its purchase of Bear Stearns, and both Citigroup and Bank of America received special direct assistance of $20 billion each. According to a summary released by Brown and Vitter, those three banks, the U.S.’s largest, would have been insolvent without the government support provided during the crisis. Since the biggest banks are even bigger today (the report states that the nation’s four largest banks are $2 trillion larger than they were in 2007), it’s hard to believe that similar support wouldn’t be granted if needed.

Dodd-Frank’s architects claim the law would prevent future bailouts. At least some of the market is convinced it would; the rating agency Moody’s downgraded the debt of major U.S. banks last week, after determining they would not have the advantage of future government support in a crisis (it’s worth noting that rating agencies receive the majority of their funding through the structured finance deals of these same big banks). But the GAO report concludes that Dodd-Frank “implementation is incomplete and the effectiveness of some provisions remains uncertain.”

The best example of this is the Federal Reserve’s Section 13(3) authority, a primary vehicle for emergency lending during the crisis. Dodd-Frank prevents the Federal Reserve from using section 13(3) to assist an individual institution, restricts even broad-based 13(3) programs from lending to insolvent firms, and adds other requirements and limitations. But the Fed has not written any 13(3) regulations yet, nor has it set any time frames for doing so. GAO recommended that the Fed establish a timeline for drafting 13(3) procedures, and the board accepted that recommendation.

The report comes at an interesting moment. Readers of this magazine may have heard of a certain Massachusetts senator named Elizabeth Warren. She has also taken on too big to fail, as an antecedent to her agenda of building an economy that works for ordinary Americans, rather than using them as giant wealth-extraction machines. And Warren has something Brown and Vitter don’t—a national platform, with the ability to shape and transform the national debate. She has already used this power to provoke incremental changes, mostly because regulators would rather be on her side than in her crosshairs. Nobody is better positioned to put this new set of facts from the GAO to use than the Warren wing of the Democratic Party.

To see this attitude change in real time, simply review the Senate Banking Committee confirmation hearings for Janet Yellen, nominated to take over the chair of the Federal Reserve. In 2009, Ben Bernanke sought confirmation for the same position, and when he was questioned about the Fed’s failures in financial regulation before the crisis, he vociferously defended the institution’s actions. Yellen, right in her opening statement, added financial regulation to the Fed’s core responsibilities, along with full employment and price stability—a huge shift. During questioning from Warren, Yellen agreed that the Board of Governors should reinstate regular principals meetings on financial supervision for the first time in 20 years, instead of relegating the decision-making to the staff level.

Yellen also directly addressed the importance of a Brown-Vitter-like regime of higher capital requirements at her confirmation hearing, telling the Banking Committee, “capital and liquidity rules… are important tools for addressing the problem of financial institutions that are regarded as ‘too big to fail.’” She even agreed that large banks get a subsidy from the marketplace. This is a far cry from just a few months ago, when a top Treasury official denied the existence of a “too big to fail” subsidy. And Yellen wouldn’t have shaded her testimony so heavily toward financial regulation if it wasn’t a point of emphasis within the Banking Committee. While the Fed may not be keen to constrain itself for future emergency financial support actions, they have to be attuned to the new disposition in Washington.

It’s not going to get any easier for Wall Street or its champions. Bad headlines persist, like the conclusion of a $13 billion settlement between JPMorgan Chase and the Justice Department over fraud in the sale of mortgage-backed securities. The headlines of a burgeoning scandal about illegal rigging of the foreign exchange markets could loom even larger, as officials promise stronger punishments for repeat offenders. In and of themselves, fines won’t hurt big banks, but they weigh on the firms’ reputations, particularly in Washington, and lead to louder calls to rein them in. Former White House economist Jared Bernstein recently attributed the “new normal” of a depressed economy to over-financialization, asking, “Who out there thinks financial markets are playing their necessary role of allocating excess savings to their most productive uses?” This could have a cumulative effect, and when Part 2 of the GAO report comes out, showing funding advantages for the same banks that perpetuate fraud, stagnate the economy, foster inequality and appeal to government for chronic rescues, the political pressure to impose real regulatory strictures could be too big to ignore.

These potential shifts can happen without legislation. Regulators have existing power to impose things like stronger capital requirements and prohibitions on special bailouts, or even break up banks that present a systemic risk. And much of Dodd-Frank has yet to be finalized, like the Volcker ruleprohibition on proprietary trading (which two federal agencies are trying to strengthen). The relative strength of our regulatory apparatus is defined by the will of the regulators to make it happen.

This goes hand-in-hand with Elizabeth Warren’s agenda, and the reform movement’s strategy for making it manifest. Warren is highly unlikely to run for President. But the next best thing is to have everyone chatter about a potential candidacy. That gives her policy arguments more resonance, and forces the regulators she helps oversee on the Banking Committee to listen. Warren’s presence makes it less possible for the normal course of Washington’s love affair with Wall Street to occur. And that’s as valuable as anything she can offer.